Employee stock ownership plans (ESOP) have been popularownership transition mechanisms for small-to medium-sized privatecompanies for many years for all manner of reasons.

An ESOP can be used to help a business owner sell all or part of their firmto cash out, it can facilitate management succession and/or it canallow employees to share the profits of their labor.

In addition, they’ve historically been a cost-effective way ofachieving those goals, too, typically costing $200,000 to$1,000,000 depending, in part, on the size of the transaction andany underlying complexities.

However, recently more and more clients tell us they’re beingpitched services to set up ESOPs with advisor “success fees”that can be $2 million or more. As a general rule, anyone beingasked to pay for that type of “success” should be skeptical.

ESOPs facilitate management and employees slowly buying outthe existing owners of a business. Beyond succession planning, there are tax reasons whysuch a mechanism makes sense. Understanding howan ESOP works shows why: The company can maketax-deductible contributions to a trust that then buys stock fromthe current owners.

The price of the stock is a fair market value, as set by anindependent business appraiser retained by the trustees ofthe ESOP. The transaction may have significant benefits forthe owner. The owner pays less in income taxes because thattransaction is taxed at capital gains rates, which is likely lowerthan income tax rates; depending on the transaction type, adeferral of the proceeds may be available.

On an ongoing basis, an S-corp ESOP reduces taxableincome, allowing the company to operate partially or totally incometax free.

Attractive as all that sounds, setting up an ESOP ischallenging. Of over 100 potential ESOP-owned companies we’veworked with in recent years, fewer than 5 percent have closed atransaction.

There are a myriad of hurdles inherent in an ESOP. However,if companies interested in ESOPs gain a betterunderstanding of those hurdles and the costs involved, they’re morelikely to reach a positive outcome at a reasonable price.

The complexity of setting up an ESOP is why somevendors offer to undertake these transactions; “success fees” arepotential hurdles that certainly need to be understood beforeentering into any agreement.

Establishing an ESOP requires a laundry list of thingsto happen and be determined, often simultaneously:

• An initial valuation is made to give a range of fair marketvalues.

• A feasibility review is made of the company’s financialsituation to assess the best deal structure, how it will befinanced and its implication for corporate structure as well as401(k) or pension contributions. Feasibility studies cost between$15,000 and $50,000.

• The ESOP’s repurchase liability is determined, assessingthe potential cost of buying the shares from the participants andre-contributing those shares to the plan. These studies costupwards of $50,000.

• How will the company be structured and willthe ESOP require a reorganization?

• Once the corporate structure is decided, the company must bevalued at fair market value.

• An independent fiduciary performs due diligence and negotiationsfor plan participants, incurring fees of $50,000 to $150,000.

• Financing, either bank, owner, or alternative financing, must bevetted. (Most financing entities require some owner participationin the financing.)

• Plan documents, summary plan descriptions, government filings,corporate amendments, non-compete agreements and corporategovernance rules must be developed, at a cost of $25,000 to$50,000. Other corporate legal review may also be necessaryto effect and ESOP transaction such as the constructionand review of purchase agreements and loan agreements.

ESOPs also bring recurring administration annual fees forservices such as an annual valuation ($15,000 to $50,000) or anannual company audit ($10,000 to $25,000), administration fees($10,000 to $40,000), legal fees ($5,000 to $50,000), independentfiduciary fees ($25,000 to $75,000) and a plan audit ($10,000 to$20,000).

On top of that, there are the soft costs such as additionalmeetings and extra employee communications.

With the complexity, negotiations, and so much paperwork andplanning to plough through, it’s little wonder that many companiesultimately decide that an ESOP is not for them. Thosethat tend to undertake an ESOP and the required diligencetend to be larger, more and consistently profitable companies.

Any company considering an ESOP should be mindful of anumber of potential pitfalls not typically mentionedby ESOP promoters:

• Fair market value as determined in an ESOP might belower than the owner expects because it may not include thestrategic value embedded in a company were it sold to an outsidebuyer or competitor.

• Bank or alternative financing can at times be difficult toobtain and expensive.

• Using an independent fiduciary to eliminate self-dealingconcerns can be costly. For example, if management is boththe ESOP fiduciary and owner, it can create conflicts andmake otherwise routine transactions complicated.

• Governance may also be expensive and cumbersome. And, quarterlyparticipant meetings may be needed.

As challenging as all this might appear at firstblush, more than 9,000 American firms, employing morethan 15 million workers and valued at more than $1.3 trillion, haveundertaken ESOP or similar plans. And 92 percent of thosecompanies are privately held.

As with many things in business, in order to getan ESOP right, it’s more important to get outstandingservice from providers than to worry too only about price.

However, paying success or other contingent fees that can amountto millions of dollars more than the other necessary professionalservices needed for the transaction must be thoroughly vetted,understood, and challenged where the value is not readilyapparent